Question

Blue Llama Mining Company is evaluating a proposed capital budgeting project (project Delta) that will require an initial investment of $1,450,000. Blue Llama Mining Company has been basing capital budgeting decisions on a project’s NPV; however, its new CFO wants to start using the IRR method for capital budgeting decisions. The CFO says that the IRR is a better method because percentages and returns are easier to understand and to compare to required returns. Blue Llama Mining Company’s WACC is 7%, and project Delta has the same risk as the firm’s average project.

Year 1	$275,000
Year 2	$400,000
Year 3	$450,000
Year 4	$425,000

Which of the following is the correct calculation of project Delta’s IRR?

2.55%

2.68%

2.04%

2.29%

If this is an independent project, the IRR method states that the firm should Accept or Reject

If the project’s cost of capital were to increase, how would that affect the IRR?

The IRR would not change.

The IRR would increase.

The IRR would decrease.

Answer 1

The IRR can be calculated as :

( $1,450,000) + $2,75,000/( 1+ IRR) ^1 + $4,00,000/(1 +IRR)^2 + 4,50,000/(1 + IRR)^3 + 4,25,000/( 1+IRR)^4

= 2.55%

So,the correct option is option A.

The firm should reject this project as the IRR is less than the WACC.

The IRR would not change as the IRR assumes that the cash flows are reinvested at the IRR at not at the cost of capital.

So, the correct option is option A

Answer 2

SOLUTION :

At IRR, cash flows are discounted at IRR and NPV = 0

Let IRR be k in decimals.

So,

NPV = 0 = - Investment + Sum of CFn / (1 + k^n)  for n = 1 to 4

=> 0 = - 1450000 + 275000/(1+k) + 400000/(1+k)^2 + 450000/(1+k)^3 + 425000/(1+k)^4

By trial and error. k = 0.025514 = 2.5514% = 2.55% approx. 

Hence, IRR = 2.55% : FIRST OPTION  (ANSWER).

Project should be rejected as WACC > IRR (ANSWER)

IRR is the rate at which if discounted, NPV is zero. So, in IRR calculation cost of capital does not come into play. Hence, IRR will not change. (ANSWER)